Investment companies for income seekers

New data suggests investors withdrew their money from open-ended equity income funds at record rates for the second month running in July. Fund settlement service Calastone estimates as much as £705m flowed out of such funds last month, following around £670m of withdrawals in June. The rush for the exit doors reflects increasing anxiety about the ability of these funds to continue generating income, as companies slash their dividends in the wake of the Covid-19 crisis; dividend income from UK-listed companies fell 57% in the second quarter of the year.

Equity income investment companies are not immune from this loss of confidence, of course. The discounts at which shares in such funds trade relative to the value of their underlying shares now stands at close to 9% - that’s up from near zero at the beginning of the year, when many funds were actually trading at a premium.

Nevertheless, there are some interesting points to consider as we compare and contrast the fortunes of open-ended and closed-ended equity income funds over the past few months. There are several reasons to think that investment companies are weathering the storm with greater resilience.

First, the move to a 9% average discount is relatively modest. Clearly, it reprensents a significant slide in a relatively short space of time, but by all historical standards, single-figure discounts are far from remarkable. There is also good reason to think discounts will narrow if and when stock market anxiety about a second wave of Covid-19 eases. Back in April, when funds were able to reassure investors that they had the means to cope with diminished dividend earnings, the initial spike in discounts caused by the pandemic eased back quite rapidly.

Second, while investment company ratings may have slipped, their fund managers have not had to cope with huge outflows of investors’ cash. This is an advantage that closed-ended funds enjoy continually, but at times of elevated market volatility it is more obvious – for open-ended managers, the huge sums disappearing from their funds in recent months will have been a painful distraction from the day job of managing money.

Third, investment companies enjoy another advantage – which explains why their discount slide has not been more significant. Investors know that the dividend reserve funds investment companies hold, with money kept back in strong years to underpin pay-outs in leaner times, are now coming into their own. Many investment companies have been able to commit to making dividend increases both this year and next despite the turmoil they face. Open-ended funds don’t have this facility available to them.

All of which is an important reminder of the case for investing in closed-ended funds if it is income that is required. Advisers who have recommended such vehicles to income-seeking clients in the past currently have a much stronger story to tell – certainly in terms of consistency of income.

The problem with these arguments is that much of the time they are theoretical. As Warren Buffet puts it so bluntly, “it’s only when the tide goes out that you find out who has been swimming with no trunks on”. At times of crisis, the pros and cons of investing in different ways to achieve a particular objective can be hugely exaggerated. So it is proving in this period for income seekers.